Recommended Games

This Pioneering Chart Pattern Is Still One Of The Best

The head-and-shoulders (H&S) top is one of the best-known patterns in technical analysis. This pattern was first written about in 1930 by a financial editor at Forbes magazine who described how the H&S forms and how it can be traded.

Many readers are familiar with the H&S pattern. On a price chart, there will be three peaks in price at the end of the uptrend, with the center peak (the head) being higher than the other two. The peaks on the sides (the shoulders) should be about equal in height.

Connecting the bottom of the peaks gives us the neckline, and breaking the neckline is the sell signal. Real H&S patterns rarely resemble the precise line diagrams seen in books, and the chart below shows one that occurred in real market conditions. The shoulders are nearly, but not quite, the same height.

View gallery

.

The problem with charts is that their interpretation is subjective. Many traders find an H&S in almost every chart they look at because some traders tend to see whatever they want to see.

Because traders see what they want to see, results vary. Some may find success looking at charts while others will suffer losses.

Using software, we can develop a precise definition of the pattern that avoids the inconsistency of less rigorous approaches. This definition can become complex.

For example, an MIT professor explained that an H&S pattern is a date series in which "the magnitudes and decay pattern of the first 12 autocorrelations and the statistical significance of the Box-Pierce Q-statistic suggest the presence of a high-frequency predictable component in stock returns."

This definition isn't practical for most traders to use because most of us don't know what all those words mean. However, by using definitions like that, objective studies can be done to determine if the pattern works.

The first study on the H&S pattern was done by economists at the Federal Reserve Bank of New York. The researchers wrote:

"Though such visual, nonlinear chart patterns are applied frequently by technical analysts, our paper is one of the first to evaluate the predictive power of such patterns... We identify head-and-shoulders patterns using an objective, computer-implemented algorithm."

The results show "profits would have been both statistically and economically significant."

Studies like this show us that old ideas can be valuable in the market when those ideas are defined precisely and followed with a disciplined approach.

Rogers was being funny, but we have found similar advice in other books and realized that we can actually follow that advice. Relative strength (RS) is a tool that allows us to find stocks that are going up.

The way to make money is to buy stocks with high RS and sell them when the RS turns down. RS can be precisely defined, programmed and tested. It can also be applied in real time to make buy and sell decisions.

Using this indicator, you could have captured a large gain in Best Buy (NYSE: BBY), one of the biggest winners among stocks in the S&P 500 Index in 2013.

In this case, the buy signal would be given after the stock starts moving up and the sell signal comes after the decline stalls.

We have found that successful trades like this can be found by using a disciplined approach to trading. The H&S pattern can be traded using only charts, but many traders would be better served by defining the pattern in a software package to help avoid buying and selling based on what they think they see.

The same is true for any trading tool. Some of the best ideas for traders have worked for decades. Those tools can now be applied consistently and objectively with automated processes that should increase profits.

The end of July ended on a mixed note with the S&P 500 still more than 1% off of highs but still right in line with the end of May. The bull market is nearing six and a half years old as well. Many investors ...

Frustrated with years of legal wrangling, a Delaware judge has given a lender 60 days to decide whether to buy the former presidential yacht Sequoia, which lies rotting in a Virginia shipyard. The 104-foot ...

Question: I have tried to make payments under protest to my homeowner association, but my board will not allow it. It said that paying an assessment by check under protest is not in the law. It refuses ...

Many investors love undiscovered hidden value in stocks, even if it is in a stock that they know. Some of the most very aggressive investors will even reach for the stars, chasing stocks that could double ...

The fall in market value of companies hit by penalties over breaches committed by third parties can be 10 times as much as the fine itself, underscoring the damage done to shareholders by misconduct, according ...

A decade ago Zhang Xiongjie was a teenage infantryman patrolling China's bleak border with North Korea. Now he stays in swanky hotels and drives a Mercedes Benz CLS - a remarkable rags-to-riches journey achieved in part by dominating one of the most obscure corners of China's unruly financial…

Skyland Petroleum Group is registered in the Cayman Islands, has a staff of about 30 and an operating history of nine months. It also has a Siberian deal with international oil giants OAO Rosneft and BP Plc that could be worth as much as $1.1 billion. Skyland’s backers are private investors from…

China’s leadership is preparing fresh fiscal spending to ensure that signs of economic weakening don’t put their 2015 growth target out of reach, a danger that was underscored by a deterioration in manufacturing in July. Premier Li Keqiang highlighted one area targeted for spending will be a…